Methods of Valuing Inventory

Inventory is a quantity of goods and materials on hand. Usually, inventory is called stock. A stock includes finished goods held for sale, goods in the process of production, raw materials, and items that will be consumed in the process of producing salable goods. Inventories are considered assets on a company’s balance sheet. Inventories are priced on financial statements either at cost value or market value.

Inventory values change according to price fluctuations. The valuation of an inventory directly affects the inventory, total current asset, and total asset balances. There are different methods of valuing inventories used by public and private companies. Such methods include:

Specific Identification method: it is the simplest method of valuing inventories. When an inventory item is sold, the inventory account should be reduced or credited, and cost of goods sold should be increased or debited for the amount paid for each inventory item. This method works only when a company knows the cost of every individual item that is sold. Specific identification method works well when the quantity of inventory a company has is limited and each inventory item is unique. The specific identification method can be practiced in businesses such as car dealerships, jewelers, and art galleries.

First-In, First-Out (FIFO) method: FIFO is a method of valuing the cost of goods sold that uses the cost of the oldest items in inventory first. This method is based on the assumption that goods that are sold or used first are those goods that are bought first. Therefore, the cost of goods bought first (first-in) is the cost of goods sold first (first-out). According to FIFO, at the end of a year an inventory would consist of goods most recently placed in inventory. If there is inflation, the cost of goods sold will be at its lowest possible amount. This would help in maximizing net income within an inflationary environment. The downside of that effect is that income taxes will be at their greatest.

Last-In, First-Out (LIFO) method: LIFO is an inventory valuing method that assumes that the last items placed in inventory are the first sold during an accounting year. Therefore, when the LIFO method is applied, the inventory at the end of a year consists of the goods placed in inventory at the beginning of the year, rather than at the end[i]. During inflation, when prices are rising, the LIFO method yields a lower ending inventory, a higher cost of goods sold, a lower gross profit, and a lower taxable income. The LIFO Method is preferred by many companies because it has the effect of reducing a company’s taxes and therefore increasing cash flow.

Average Cost method: the average cost method takes the average of all units available for sale during the accounting period. The average cost method uses the average cost to determine the value of the cost of goods sold and ending inventory.

When the income tax of a taxpayer can be calculated only by including the inventories it must be taken on a basis prescribed by the IRS. The tax will be calculated in as close conformance as possible to the best accounting practice in the trade or business and most clearly reflecting the income[ii].

The market value of goods on the inventory date is compared with the cost of every item under the lower of cost or market method. In comparison, the lower value of the two is the inventory value of a particular item. The total inventory will be the aggregate of the inventory values calculated for each item. It will not be the lower value of the total cost or the total market value of all the items.

When inventories are valued at a lower of costs or market, it would result in the allowance of a deduction for the decline in inventory value before it is realized by the sale of the inventory. In such circumstances, tax law permits the deduction of an unrealized loss.

During a period of steady or rising prices, inventory value will be same under cost or lower of cost or market method. When there is a fall in prices, a cost based inventory will be higher than that valued at a lower of cost or market method. A taxpayer gains a larger profit during valuation on the basis of cost for the accounting year. Generally, over a period of two years or more, the total profit or loss under cost or lower of cost or market method will be the same. However, the total tax will be different.

Inventory rules are not considered uniform. The best accounting practice prevalent in the industry should be given effect[iii]. When a taxpayer has used one inventory valuation for more than one accounting year the consistency in the practice should be given more weight than application of a new inventory valuation method. However, the prior used method should be in accordance with the regulations. The IRS has the right to question a method of valuation of inventory[iv]. If the method a taxpayer is using for valuing inventory does not reflect income, the taxpayer can be asked to change it[v]. When a taxpayer has more than one trade or business, the IRS can require consistency in the inventory valuation method. The method used in one trade or business should be followed in another business as well. However, the same method of valuation can be applied only when the method clearly reflects income.

Some goods in inventory cannot be sold at a normal price or in a normal way because of damage or imperfections. Such goods are valued at selling prices minus the direct costs of disposition. When the goods are raw materials or partly finished goods that are held for use or consumption, the inventory can be valued only upon a reasonable basis. The usability and condition of the goods should be given consideration before valuation. However, the valuation should not be below scrap value. The selling price of merchandise can be calculated by the price actually being offered for the goods for a period ending not later than 30 days after the date of listing the goods for sale. Certain goods will be produced in excess of current demand. Such goods are valued at a replacement cost. However, a taxpayer can not ‘write down’ the cost of these goods to their net realized value[vi].